Topic 8: Option Markets and Valuation Flashcards Preview

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Flashcards in Topic 8: Option Markets and Valuation Deck (12)
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1

In the money call and put

- Call: market price>exercise price

- Put: exercise price>market price

2

Out of the money call and put

- Call: market price < exercise price

- Put: exercise price < market price

3

At the money call and put

- exercise price and asset price are equal

4

Payoffs and Profits at Expiration - Calls

- Notation
Stock Price = ST Exercise Price = X

- Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X

- Profit to Call Holder
Payoff - Purchase Price

- Payoff to Call Writer
(ST - X) if ST >X
0 if ST < X

- Profit to Call Writer
Payoff + Premium

5

Payoffs and Profits at Expiration - Puts

- Payoffs to Put Holder
0 if ST > X
(X - ST) if ST < X

- Profit to Put Holder
Payoff - Premium

- Payoffs to Put Writer
0 if ST > X
(X - ST) if ST < X

- Profits to Put Writer
Payoff + Premium

6

What is a protective put?

- long the stock and long the put

7

What is a cover call?

- own the stock and write a call

8

What is a collar?

- Collars are the combination of buying stocks, buying put and writing calls

- Suppose you are holding IBM, selling at $100. You can buy protective put with exercise price of $90, and write call option with exercise price $110. The two premiums may cancel out

9

What is a long straddle?

- long call A, long put A (same exercise price A=X

- When to use: If market is near A and you expect it to start moving but are not sure which way to move.

- Profit: Profit open-ended in either direction. At
expiration, break-even is at A, plus or minus cost
of spread

- Loss limited to cost of spread. Maximum
loss incurred if market is at A at expiration

10

What is a short straddle?

- Short call A, short put A (same exercise price A=X)

- When to use: If market is near A and you expect market is stagnating. Because you are short options, you reap profits as they decay—as long as market remains near A

- Profit: Profit maximized if market, at
expiration, is at A. In call-put scenario,
maximum profit is credit from establishing
position; break-even is A plus or minus
that amount

- Loss: Loss potential open-ended in either
direction. Position, therefore, must be
closely monitored and readjusted to
neutrality if market begins to drift away
from A

11

What is a bull spread?

- Bull spread: long call A, short call B; or long put A, short put B (A=X1, B=X2)

- When to use: If you think the market will go up somewhat or at least is a bit more likely to rise than fall. Good position if you want to be in the market but are unsure of bullish expectations. This is the most popular bullish trade

- Profit: Profit limited, reaching maximum if market
ends at or above B at expiration. If call-vs.–call
version (most common) used, break-even is at
A + net cost of spread

- Loss: What is gained by limiting profit potential is
mainly a limit to loss if you guessed wrong on
market. Maximum loss if market at expiration is
at or below A. With call-vs.-call version,
maximum loss is net cost of spread

12

What is a bear spread?

- Bear spread: short call A, long call B; or short put A, long put B

- When to use: If you think the market will fall somewhat or at least is a bit more likely to fall than rise. This is the most popular position among bears because it may be entered as a conservative trade when you are uncertain about bearish stance

- Profit: Profit limited, reaching maximum at
expiration if market ends at or below A. If put-vs.
–put version (most common) used, break-even
is at B - net cost of spread

- Loss: By accepting limit to profits, you gain a
limit to risk. Losses, at expiration, increase as
market rises to B, where they stabilize. With putvs.-put version, maximum loss is net cost of
spread